The Virtual Steel Mill

A comprehensive approach to derivatives for the ferrous industry

2

Creating the Virtual Steel Mill – CME Group’s

comprehensive approach to derivatives for the

ferrous industry

Over the past few years a variety of steel and related ferrous

cleared or exchanged traded contracts have been launched,

all with noble ambitions of providing price transparency while

enabling the industry to protect its revenues from the ravages

of price volatility. These product offerings have achieved

some measure of success, including the CME Group’s own

US Midwest Domestic Hot Rolled Coil contract (http://www.

cmegroup.com/trading/metals/ferrous/hrc-steel.html),

which has seen a gradual rise in traded volumes and open

interest. None however has fully captured the imagination of

this industry, principally because the current product slate

has attempted to retrofit steel into a non-ferrous model,

failing to appreciate that there are a number of distinct risk

factors located throughout the supply chain. Put simply, one

size does not fit all.

CME Group’s unique approach

After considerable industry engagement the CME Group

appreciates that a comprehensive solution for the ferrous

industry is required, one that both treats the industry

holistically, cognizant of the highly interdependent nature

of the players, while respecting that individual solutions are

required to service the respective moving parts.

Our vision therefore is to create a virtual steel mill where raw

materials, semi finished and finished steel products can all

be bought or sold, either on a spot or a fixed forward basis,

without disadvantaging other parties in the supply chain.

Through the use of CME Group’s ferrous product suite, miners

can now sell iron ore on either a contract or spot price basis

to steel mills; thus, maximizing their revenue. Simultaneously,

steel mills can purchase Exchange contracts to hedge against

any rise in this input cost. With input costs now known and

protected, mills can, in turn, offer billet or hot rolled steel

outputs to their clients on a fixed forward price basis, having

locked in profit margins. End consuming industries such

as automotive, white goods and construction can likewise

benefit from buying on a fixed input basis, as they have long

been able in aluminium or other base metals. They can also

choose to hedge their steel risk by purchasing downstream

steel contracts through CME Group.

 

Volatility In Ferrous Product Prices

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Why are multiple contracts needed? Why can’t you

hedge steel risk using one contract?

In a perfect world using one steel or ferrous product, such

as hot rolled coil or iron ore, to hedge price risk up and down

the supply chain via use of a premium and discount structure

would be ideal. This is the mechanism that has worked so

well in the base metals industry until recently where the

concentrates market has become disconnected from the

semi-finished product.

Unfortunately, we don’t live in a perfect world — lack of price

transparency, changes in global trade flow patterns, growing

competition for raw materials, demise in annual benchmark

prices and different production methods (electric arc furnace

vs. blast furnace to basic oxygen furnace), among other

factors has lead to a price disconnect between supply chain

segments. As a consequence, historic correlations, which

once held strong, have broken down as product prices diverge

and spot pricing becomes the norm. (We would hasten to

add that the changes in pricing structure and consequential

break down in correlations are something endemic within the

ferrous industry and are not a product of exchange activity.

Indeed the evolution of steel pricing is something which pre-

dates exchange contracts and provides one of the conditions

for the listing of any exchange traded contract.)

To illustrate the point, following is a look at some

price series for various ferrous products.

The first set of correlation charts show Platts’ iron ore price

set against the LME’s steel billet. While billet in the west is

primarily produced from scrap, in China, the world’s largest

steel producing country, billet is manufactured predominately

from iron ore. The first chart clearly shows that over a three

year period billet and iron ore do not correlate. The second

chart, which derives correlation over a shorter one year

period, also shows correlation, albeit slightly better, still

insufficient to enable either product to be used as a basis to

price the other. (Results are much the same if one uses iron

ore prices from TSI).

Chart of the virtual steel mill

IRON ORE

Rebar Wire Rod Structurals MerchantBar

Hot RolledStrip US/EU

Plate

Cold Drawn Bars

Wire Products

Cold Rolled

Galvanized

Coated

Tubes & Pipe

BILLET / BLOOMSLAB

METCOAL SCRAP PIG IRON

EAF RouteBF/BOF Route

Flat Products Long Products

DRI/HBI

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One might argue the LME steel contract more properly reflects the merchant flow of billet in the Black Sea/Mediterranean

region, and is manufactured via an electric arc furnace method using scrap as the main input, thus it should be compared

to Turkish scrap rather than the import price of iron ore into China. However, we see a fundamental lack of correlation which

precludes the use of one product to hedge the other. (We have chosen to use Platts pricing, partly because CME Group’s

contract is based against it, but also because it is assessed daily, as is the LME’s billet. The short time frame reflects the official

launch of Platts index. It is however illustrative of the present lack of correlation which is far more important, given current credit

cycles, than long dated price harmony. Where possible we have charted both).

This issue is not isolate to any one exchange. The lack of upstream and downstream correlation exists across virtually the entire

supply chain irrespective of index provider. In the following charts you can see the lack of price relationship between various

ferrous products.

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The exception to the above is Black Sea billet and Turkish rebar, which shows a good correlation looking at a Platts derived

indices. The correlation between LME billet and Turkish rebar run over the same time period is, again, very poor.

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Why the breakdown in market dynamics?

There is no one reason that can fully explain the breakdown

in price correlations between the various product segments.

It is instead a confluence of factors that together can help

us understand why the prices of seemingly highly related

materials are moving independently of one another.

The first factor to consider is the rapid ascent of China as a

steel powerhouse. Over the past ten years, China has gone

from a 100 million tonne producer of steel to the world’s

largest, with output exceeding 700 million tonnes in 2011

according to recent CISA estimates. This has not been a

straight forward process. At times, China imported large

amounts of finished steel, helping to drive up global prices

in the process. At other times, the country switched to being

a net exporter, causing global prices to fall. It is important

to note that these minor export periods did not necessarily

coincide with diminished imports for raw materials. Rather,

they reflected short-term phenomena in China where

the domestic price for steel fell below the global price

resulting in traders arbitraging physical material to extract

additional value. China’s appetite for raw materials remained

undiminished over the period, resulting in a decoupling

between global finished steel prices, which remained highly

volatile, and raw material prices, which remained firm.

Another consequence, leading from the first, has been the

demise of the annual benchmark price for iron ore as mining

companies seek to optimize their revenue. These miners,

with full backing from shareholders, have taken a calculated

risk that in the short to medium term demand for iron ore will

remain strong as consumption outstrips the supply response

from both Brownfield and Greenfield operations.

A result of iron ore moving from benchmark to spot pricing

has been volatility, with the underlying value now reflecting

more closely market fundamentals, which ebb and flow for

a variety of reasons. The announcement of a government

stimulus project in China, flooding in Australia or Monsoons

in India can all lead to rapid price rises. Likewise, destocking

phases or poor economic news can similarly result in a

decline in the iron ore price as the market anticipates

waning demand.

The following charts from Macquarie Commodities

Research illustrate the view of many in the market that iron

ore will remain tight in the medium term with associated

strong price cycles.

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Source: Macquarie Research, September 2010

Source: Macquarie Research, September 2010

Supply Prospects

Changes in Seaborne and Chinese Iron Ore Supply

8

It is not only iron ore that is impacting the steel market. Strong demand for metallurgical coal has resulted in rapid price

movements over the last few years as evidenced by the price rise between 2007 and 2008 and the decline again in 2009.

Continued strong demand growth for metallurgical coal is anticipated with China, India and elsewhere seeking international

supplies to augment domestic resources. This will undoubtedly create supply challenges for the industry.

Seabourne Met Coal Demand and Supply

Incremental Seabourne Met Coal Demand Growth by Region (Mtpa)

9

With short and medium term demand constrained, spot pricing in this space is now evolving, much as occurred for iron ore, with

producers and traders seeking to maximize value of this scarce resource as seen in the chart below.

Consequences of the global economic crisis were a third contributor that helped to exacerbate the price disconnect between

ferrous products. While termed a global crisis, a fact hotly contested in many quarters, from a steel perspective it was very

much a western phenomena with many Asian and South American countries scarcely impacted. This can be observed by the

difference in capacity utilization rates and apparent consumption figures between China, Nafta and the Europe 27.

Platts Prem Mid Vol HCC FOB Aus $/t

Capacity Utilization (% of nominal capacity)

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Equally telling is the decline in consumption for raw materials and hot rolled coil in Europe, Japan and the US, whereas demand

in China and India continued unabated. The following two charts from CRU Strategies illustrate the demand difference

between regions.

China’s capacity utilization expected to improve out to 2013

2004 2005 2006 2007 2008 2009 2010p 2004 2005 2006 2007 2008 2009 2010p

China 48.953 52.703 61.835 68.789 70.058 74.871 86.999 China 72.507 101.887 131.079 165.709 174.370 217.902 261.325

USA 64.476 64.482 67.339 67.870 63.018 41.522 57.064 USA 70.622 60.898 65.458 61.804 56.148 34.670 50.281

Japan 39.083 38.571 41.765 43.026 41.862 28.660 33.220 Japan 51.917 50.739 50.178 52.377 51.277 35.142 49.036

Korea (S.) 21.926 22.649 23.330 25.840 25.729 23.266 27.657 Korea (S.) 24.563 26.129 27.257 30.300 31.762 26.350 33.521

Russia 25.596 27.421 30.616 33.192 33.249 22.560 26.624 India 19.058 21.090 24.755 27.336 23.943 25.148 29.078

India 18.780 17.451 16.886 16.224 17.516 22.212 25.680 Germany 21.361 20.798 22.891 24.073 21.901 15.393 18.500

Turkey 17.288 17.665 20.823 23.276 23.954 21.855 25.045 Russia 14.433 14.669 16.465 17.637 16.177 13.110 17.452

Germany 18.651 18.126 19.432 19.589 18.905 13.882 21.810 Brazil 11.290 11.295 11.317 13.214 12.582 10.152 14.431

Italy 19.746 19.472 21.685 22.078 21.720 14.936 20.585 Taiw an 12.323 10.808 9.899 9.636 8.760 6.543 9.164

Spain 14.089 14.292 15.389 15.750 15.528 12.199 14.059 Italy 13.448 13.541 15.692 14.181 14.210 7.468 8.173

N. America 80.853 80.868 84.178 84.725 79.135 54.243 73.340 N. America 87.704 76.606 82.959 77.620 71.166 47.174 65.835

S. America 12.836 12.889 14.327 14.495 16.013 13.525 17.473 S. America 17.444 17.421 18.450 19.754 19.535 15.139 20.435

Europe 118.336 116.091 127.980 132.837 129.569 98.630 126.009 Europe 97.326 95.212 105.250 106.259 98.312 68.434 82.090

CIS 43.309 44.970 46.596 49.914 48.276 35.659 39.935 CIS 21.333 21.387 22.077 24.183 21.584 17.363 23.745

Asia 154.502 158.791 174.105 187.700 188.585 174.943 200.197 Asia 192.453 223.333 254.697 299.751 304.370 324.125 396.588

Middle East 4.281 5.035 6.084 5.941 5.338 5.518 6.061 Middle East 6.559 7.899 6.784 9.954 7.984 8.124 10.217

Africa 4.281 5.035 6.084 5.941 5.338 5.518 6.061 Africa 6.559 7.899 6.784 9.954 7.984 8.124 10.217

Oceania 2.630 2.613 2.521 2.882 3.047 2.117 2.904 Oceania 4.671 4.678 4.515 5.755 5.040 3.918 4.930

World total 421.026 426.293 461.875 484.436 475.302 390.154 471.981 World total 434.048 454.435 501.515 553.229 535.974 492.400 614.058

D a ta : C R U S tra te g ie s

G lo b a l m a r k e t fo r fe r r o u s s c r a p , 2 0 0 4 -2 0 1 0 (m

t o n n e s )

Apparent consumption

D a ta : C R U S tra te g ie s

G lo b a l m a r k e t fo r h o t -r o l le d c o i l , 2 0 0 4 -2 0 1 0 (m

t o n n e s )

Apparent consumption

Global Market for Ferrous Scrap, 2004 – 2010

(m tonnes)

Global Market for Hot-Rolled Coil, 2004 – 2010

(m tonnes)

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Future challenges and opportunities –

what does the future hold for steel?

CONCLUDING NOTE:

Holding the steel industry back from embracing ferrous

metals derivatives products has been a natural reluctance

to trade futures because there are established or traditional

ways of doing business. Most often, this means long-term

cash market contracts. One of the chief concerns expressed

by steel producers wary of derivatives markets are some of

the same concerns that CME Group has heard from other

industries: financial institutions will benefit from these

contracts more than the industry.

Steel prices have been moving for years without the existence

of speculators or financial institutions. Steel derivatives

contracts enable producers or consumers to lock in prices,

and not have to wonder what happens if the price changes

tomorrow.

Though it may take some time for steel mills to fully embrace

futures contracts, end users have already shown wide

interest, which may mean that maturity for this market is not

particularly far off. As a spokesman for Ford Motor Company

recently said, “Reducing price volatility ultimately helps us

more efficiently produce new vehicles. A steel futures market

gives us an additional tool for hedging price risk.” (The Wall

Street Journal, “Steel Users Seek Futures” 9/21/11)

Supporting this view is the fact that CME Group contracts

in iron ore and hot rolled coil saw record trading volume in

August 2011, a signal that multiple links in the supply chain

are moving towards futures.

Taking the new global demand for ferrous metals – most

notably surging demand in China – and each of the

interconnected parts of the steel supply chain into

consideration, a suite of derivatives products for ferrous

metals containing relevant products for specific industries and

regions best meets the industry’s risk management needs.

Quality products in this area have existed for several years,

and have helped individual segments of the steel supply

chain manage their costs. However these products are

most often meant for only one link in the supply chain.

Iron ore producers, steel mills, merchants, end users, and

financiers all must have the option to manage their cost with

products that fit their business needs, and appeal to the risk

management possibilities within their industry.

Our virtual steel mill takes each of these industries into

account. In agriculture, a wheat farmer most likely does not

have a need to purchase corn futures. Likewise, an iron ore

producer has little use for hot rolled coil futures. Different

products appeal to different parts of the industry. They must

each – in order to manage input and output cost, and to avoid

passing along cost to the next link in the supply chain – be

able to use derivatives markets to manage risk on a global

scale. A virtual steel mill makes that possible.

For more information, contact:

Martin Evans

Associate Director, Research & Product Development

phone: +44 20 3379 3791

email: martin.evans@cmegroup.com

12

Global Iron Ore Demand to Almost Double by 2019

02 Sep 2011

Rio Tinto said that the world needs at least 100 million tonnes

of additional iron ore supply each year for the next eight years

to meet demand growth projections in steel making.

At that rate, global iron ore production would almost double

over the period, based on industry trade data largely covered

in the early years at least by expansions underway among the

major miners, including Rio Tinto.

Steel Consumption and GDP Per Capita

Intensity curve shows markets like China, India or Brazil still very far away of reaching

its peak of consumption in Kg/capita

Mr. David Joyce head of expansion projects for Rio Tinto’s iron

ore group, told an industry conference in Australia on mining

in Africa said that “This represents a staggering increase in

demand as markets like, China, India, Indonesia, Vietnam

and countries in Africa and South America continue to

industrialize and urbanize.”

Emerging markets comprise 75% of global iron ore demand

and 90% of that is Chinese demand.

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Rio Tinto, the world’s second largest producer behind Brazil’s

Vale also said its Simandou iron ore joint venture with China’s

Chinalco in Guinea was on track to make its first shipment by

mid-2015.

Mr. Joyce said that “We remain committed to ambitious

timeframes of shipping our first tonnes of iron ore by mid

2015 adding that the company has invested USD 1.5 billion

in the project to date.”

The joint venture targets initial production from the

Simandou mine of 70 million tonnes per year, with estimates

for potential future output reaching up to 170 million tonnes.

Mr Joyce also said Rio Tinto was on track to expand its iron

ore production capacity in Western Australia to 333 million

tonnes a year from about 225 million now.

Rio Tinto last month moved up it’s the target date to reach

the higher figure by six months to the first half of 2015.

Anglo American expects to nearly double iron ore production

to around 80 million tonnes by 2014 as it digs new mines in

Brazil and South Africa.

But that’s still well below current production figures for others,

including Vale, BHP Billiton and Fortescue Metals Group each

of which has massive expansion plans in the works.

BHP Billiton is proceeding with a USD 7.4 billion expansion of

its Western Australia iron ore operations with its own share of

the investment totaling USD 6.6 billion.

(Sourced from Thomson Reuters)

Steel Consumption in 2050

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China’s economy is still light on steel

• Cumulative Steel consumption acts as a proxy for the amount of steel in an economy

• China’s cumulative steel consumption is only 10–20% of major development economies

Cumulative Steel Consumption Per Capita 1900-2009

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